Wednesday, 9 March 2016

Algo isolation driving markets bonkers.

The world of finance can be blinded by its own feedback. It’s like sitting in a hall of mirrors where all the other people you are looking at for clues are actually you.

The most basic of markets works on the physical supply and demand of the good as dictated by the producer and the consumer. The addition of intermediaries, speculators and investors is like plumbing in a huge storage tank in the pipe that runs between producer and consumer. This tank fills up and runs down as expectations of future supply and demand are anticipated by those wishing to hedge or make profit. In the simplest example it’s oil storage in the oil market. It’s the warehouse where the physical is stored against futures. Yet it is also represented in the complexity of interest rate swaps and the most bizarre of speculative financial products.

But the volume taken into that tank will still eventually have to end up with the consumer of the good. The tank is only storage. Buying commodity futures? You'll need to sell them back at some point or physically deliver. The long term true supply and demand rests with producer and end consumer.

The world of finance is effectively that tank on strapped to the supply and demand pipe of everything tradable with a forward value, representing expectation of future demand. If everything traded spot with no storage facility there would be no financial market. Without the dimension of time finance vanishes (so it is probably a good thing that time is regulated!).

But the tank of financial markets can get so complex that those acting in the dankest murkiest parts furthest from the supply and demand pipes find it hard to see what is going on and instead look for indicators from others nearby. The markets since January have, I would strongly suggest, been more driven by the price of other financial instruments than they have by changes in the underlying economy. Oil falling and rallying by 35% has not been because of a 35% change in physical supply and demand but on the expectation of what may happen. The moves in equity prices oscillating -20%/+10% have not reflected actual changes in profitability of companies but rather expectations based on moves in credit, oil and interest rates. The sharp move up in metals hasn’t been caused by smelters suddenly consuming masses more, but the change in expectation driving those who had borrowed to short to buy back to cover and those anticipating future demand rises to buy and store.

All the while the new driving force in the markets, algorithmic driven funds, look at the price actions around them in the finance tank and follow the trends. This whips up more moves in the finance world which leads to the algos noticing that the real world data is having smaller impacts relative to the actions of prices around them. They then rebalance the weightings of real world factors and focus more and more on price correlations. This drives the disconnect between finance and economic reality so far that the tank of finance is in danger of spawning off as its own budding universe of introspection and self importance leaving reality far behind.

Is this not what we are seeing? The year of 2016 has been relatively shock free as far as new issues go yet markets have been bonkers. It’s been like driving a car with loose steering linkages, with the steering wheel being swung hard left and right to just keep going in a straight line.

Algorithmic trading is one thing, but applying algos to investing with the new game of robo-advisory will no doubt result in an 'algo squared' situation where the algo robo-advisors see algo-trading systems doing well and allocate more money to them. It is building a nasty bubble, not a bubble in price but a bubble in price volatility as the amplitude of oscillations in the market is driven by the rise of the robots. This is not exactly what those calling for computer driven trading wanted when they insisted that computers would tame the excess of of human trader emotions.

So buy volatility. Not for the classic reason that you think the markets will dump, but for the purist reason that the recent bonkers price moves will probably get worse. Meanwhile the real world will drift along minding its own business and wondering what all the fuss is about.

1 comment:

Funnily enough, something I concluded myself. Mispricing of volatility seems to be becoming more marked.

In the era of 'fighter jet profiles' (see MM non normal, fat tailed charts today) and a possible bear where heightened volatility is a feature, it makes sense to devote a small percentage of funds to such speculative bets methinks. We also have the added but unknown impact of regulation on liquidity.